(From the Financial Literacy Blog) – On August 24, 2022, President Biden and the U.S. Department of Education announced a three-part plan to provide relief to federal student loan borrowers. One part of the plan is to provide targeted debt forgiveness, with up to $20,000 in debt cancellation for eligible borrowers. Federal loan borrowers who received Pell Grants are eligible for up to $20,000 in debt cancellation, while non-Pell Grant recipients are eligible for up to $10,000––as long as their individual income is less than $125,000 ($250,000 for married couples). For some, the forgiveness may wipe out all of their student loan debt. While their debt would be erased, it could negatively impact their credit—albeit slightly.
What Is Credit?
Within the U.S. financial system, credit is the ability to borrow money to access goods or services with the understanding that the borrower will pay it back later. Credit unions, banks, and other lenders issue credit to people who want to obtain something now, but either can’t or don’t want to pay for it immediately. Before someone is granted any credit, lenders determine the borrower’s creditworthiness, or how likely they are to pay the money back in full and on time. Creditworthiness is represented by a credit score, which is a number between 300 and 850. The higher the score, the better one’s creditworthiness.
Will Student Loan Forgiveness Affect Credit?
If federal student loan borrowers were to have their student debt completely forgiven, they may notice a dip in their credit scores. However, they shouldn’t be overly concerned about it and it shouldn’t deter them from applying for forgiveness.
Why Might Credit Scores Drop after Forgiveness?
Having student loans contributes to one’s credit mix, which refers to the variety of loans they have. Other examples include mortgage loans, auto loans, and credit cards. When lenders are deciding whether to offer someone a loan and at what interest rate, it helps the lender to see a steady payment record on a mix of credit types because it shows that the person can manage the different obligations that come with borrowing all kinds of debt. Student loan forgiveness takes away from a person’s credit mix, which could lead to a slight, temporary dip in their credit score.
Another reason why someone might notice a slight dip in their credit scores is because student loan forgiveness may lower the average age of their credit accounts. This is because student loans are often the earliest loans people take out. A longer credit history shows a person has more experience using credit, and this helps lenders accurately measure the risks they take when lending to that person. If someone has a history of on-time payments, it indicates they’re likely to make their payments on time if a lender gives them credit. Despite any slight dip in credit scores, the financial benefits of forgiveness outweigh the minimal dip.
Could Forgiveness Improve Some Borrowers’ Scores?
If someone received the student loan forgiveness, but it didn’t completely wipe out the entirety of their balance, they may notice a credit score improvement. This is because the student loans are still contributing to their credit mix and the average age of their credit accounts. On top of that, eliminating a portion of their debt decreases the amount owed to lenders, which is the second biggest contributing factor to credit scores. If someone is using a lot of their available credit, it may indicate they are overextended––making them look like they have a higher risk of failing to pay their debts. Student loan forgiveness of $10,000 or $20,000 will lower their amounts owed––potentially leading to increased scores.
What Should Borrowers Keep in Mind?
The bottom line is the student loan forgiveness is well worth it. The possibility of a quick dip in one’s score should not make people shy away from seeking forgiveness. If forgiveness negatively impacts someone’s score, it may only be a 5- to 10-point drop. As long as people keep making their other loan payments on time, their score can rebound relatively quickly. The positive implications of debt forgiveness far outweigh any temporary impact on credit!
If you’re looking for ways to improve your credit score, contact your local credit union for help.
WMTW Total Money Coverage: Debt Forgiveness and Credit
Jen Burke, League AVP – Communications & Outreach, offers her insight to WMTW concerning how student loan forgiveness may affect borrowers’ credit scores.